Rob Arnott: We have negative real interest rates, and inflation rates in the range of 5%-7%. So, Arnott says, “if inflation kicks up another 1% or 2%… this creates some fairly serious downside risk for equities if the Fed continues on it’s current path.”

Submitted by IWB, on September 23rd, 2011

“Absent deficit spending, we’re mired in the worst depression since the Great Depression,” observes Rob Arnott, “and the Fed may be making things worse.” We have negative real interest rates, and inflation rates in the range of 5%-7%. So, Arnott says, “if inflation kicks up another 1% or 2%… this creates some fairly serious downside risk for equities if the Fed continues on it’s current path.”

With continued volatility in all the markets, King World News interviewed five time Graham & Dodd Award Winner, Rob Arnott, who oversees more than $80 billion as the Founder & Chairman of Research Affiliates. Rob sub advises the Pimco All Asset Fund and mutual funds and ETFs for Schwab, Powershares and Nomura. When asked about what he sees happening with stocks and the economy going forward, Arnott stated, “When real interest rates are 2%-4% and inflation rates are 2%-4% you get a really nice peak where the average P/E ratio is north of 25 times earnings. The interesting thing is both of these numbers are within the control of the Fed, the Fed can control the rate of inflation and tacitly can therefore control the real rate of interest. ”

Rob Arnott continues:

Where are we now? We have negative real interest rates. Okay, that’s pretty alarming. We also have inflation rates (if) correctly accounted, probably in the 5%-7% range. If inflation kicks up another 1% or 2%…This creates some fairly serious downside risk for equities if the Fed continues on it’s current path.

Unfortunately I think they will. Unfortunately enabling bad behavior is what they do to try to avoid an economic downturn. Well, the downturn is already here. Absent deficit spending, we’re already mired in the worst depression since the Great Depression.”

When asked about the proposed stimulus package Arnott remarked, “Let me postulate another idea entirely, Milton Freidman 50 years ago suggested that the right way to deal with poverty is a negative tax. As an example, you have somebody who barely managed to graduate from high school, lousy grades, no job experience, no job skills, how is that person going to get a job? Well, (simple hypothetical example) if an employer is allowed to hire him for a buck an hour, he’ll get a job, but if an employer is required to pay them $8.00 an hour, they won’t.

You wind up with a person basically being told that you’re unemployable now, we unfortunately have to leave you in that situation and that means the American dream is not for you. The other scenario is you say, you know your market clearing price is pretty low right now, it’s a buck an hour. So we’re going to hire you for a buck an hour and we’ll pay you a negative income tax of $7.00 bucks an hour, so you’re making $8.00. Is the employee going to care whether the eight bucks comes from the employer or largely from the government? Of course not.